Bank runs occur when many individual account holders withdraw large sums of money at the same time out of fear that the bank might fail. Here’s how bank runs works.
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What Is a Bank Run?
A bank run can occur when customers want to withdraw large sums of money in a short period. This situation can occur in a fractional banking system in which banks only keep a fraction of deposits on hand as cash. They use the rest of the cash to generate income, such as with loans or by investing in interest-bearing assets. However, because banks usually only keep a fraction of deposits on hand as cash, they can run into trouble if customers want to withdraw too much money too quickly.
Such is the problem with bank runs. In some situations, many customers might withdraw their cash at once because they fear they won’t be able to access it soon. This can happen when people think the bank may soon become insolvent. In the old days of banking, this could create a situation where people were lined up at banks to withdraw their money, creating even more fear and rush to withdraw funds. This situation could create a feedback loop. Ultimately, the bank could end up running out of money to cover withdrawal requests – hence the term bank run.
When a bank run occurs, banks may resort to desperate measures. For example, a bank might liquidate their loans and sell assets ultra-cheap to cover its obligations.
What Causes Bank Runs?
As mentioned, bank runs are usually the result of fear over the potential insolvency of a banking institution. For example, during the period of the Great Depression, there was a bank run when people saw that others were withdrawing mass sums of money. It began with many withdrawals at a bank in Tennessee, which eventually spread to other banks.
Eventually, a situation in New York led to $2 million being withdrawn from the Bank of the United States. That’s equal to over $34 million in today’s dollars. Bank runs can start with what seems like a relatively minor situation that becomes severe as the feedback loop continues.
How to Prevent Bank Runs
There are many ways to prevent bank runs or lessen their impacts. One of the most effective ways is with regulation. For instance, the bank runs of the 1930s prompted the creation of the Federal Deposit Insurance Corporation (FDIC), which insures customer deposits. The government also established reserve requirements, which require banks to maintain a certain percentage of deposits as cash.
Banks can also take measures to prevent runs on their deposits. Here are some preventative measures banks might take:
Slow the Pace
Banks do have inflows of cash, such as when customers make loan payments. But due to the nature of fractional reserve banking, they might not have enough cash if customers try to withdraw too much cash too quickly. Thus, a simple measure that can be effective is to slow the pace of withdrawals. Historically, physical banks would shut down a few days if their cash reserves were running low. Today, banks might limit the amount of money people can normally withdraw in a day.
Banks often serve as lenders but can also be borrowers if they find their cash reserves are running low. This can help the bank avoid having to declare bankruptcy. The bank may need a large loan or loans in this case.
Use Term Deposits
Term deposits, like certificates of deposit (CDs), can help banks slow the pace of withdrawals. These accounts pay customers interest on their deposits. In exchange, they agree to keep their money in the account for a pre-determined period. This makes the bank’s deposits more predictable, so it knows when it might have a large outflow of cash.
In the modern banking system, banks only keep a portion of deposits on hand as cash – this is known as fractional reserve banking. This allows the bank to use the rest of its deposits to extend loans to customers or to invest in interest-bearing assets.
However, this can lead to a rare situation where customers try to withdraw more money than the bank has on hand. Certain measures, such as the creation of the FDIC, have helped make customers more confident in the solvency of banks. Other measures, such as term deposits, can help slow the outflow of cash.
Tips for Opening a Bank Account
- If you plan to open a bank account, be sure to check SmartAsset’s checking and savings guide. Some checking accounts are better than others; for example, some have monthly fees and minimum account balances. Be sure to research the best options before opening a new checking account.
- A financial advisor can help you work through your banking needs and put together a plan that works in your unique situation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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